Foreign Exchange Crunch Now, Then, Tomorrow

A country’s economic growth depends, among others, on the extent of its financial resource mobilization of both local and foreign currencies without which it is hardly possible to bring economic growth. Thus, it has a tremendous role in bringing economic development through availing the financial resources required for implementing the development plan. Moreover, foreign currency mobilization and reserve position are important determinants of all well-managed economies.

Developing countries like Ethiopia are characterized by the existence of a long lasting foreign exchange gap, due to their poor foreign currency mobilization, which is a factor for their chronic balance of payment (BoP) crises, deterioration of terms of trade (ToT), foreign currency shortage and huge debts. More importantly, for developing economies, the availability of adequate foreign currency reserves is a major determinant of their economy due to the dependence of the domestic economy on external factors, in which both domestic production and consumption are highly dependent on import of goods and services from the international market and the existence of ineffective demand and supply.

Currently, Ethiopia is experiencing economic growth, and to continue along this successful path and reach middle-income status by 2025, the government is implementing a number of admirable development plans. A case in point being the Growth and Transformation Plan (GTP), a major policy framework composed of many mega projects, including the Grand Ethiopian Renaissance Dam (GERD), where the country’s economy is targeted to gear towards industry rather than agriculture.

Accordingly, to achieve the admirable goals set out in GTP, that require a significant amount of foreign currency, the government is expected to develop and implement a strategy that promotes and improves foreign currency mobilization.

On the contrary, the country is currently facing a severe foreign currency shortage that is retarding investment and business activities, increasing inflation and slowing down the overall economic activity of the country. Not surprisingly, the foreign currency reserve is lower than it should be, foreign exchange earning from export does not finance the import of fuel and the manufacturing industry routinely struggles to gain foreign currency permits for the import of raw materials and capital goods.

These problems snowball into negatively affecting employment, inflation and production, there by slowing down the overall performance of the country’s economy. And as foreign currency shortage has been a chronic problem in Ethiopia for over half of a century, it continues to exacerbate the long lasting balance of payment (BoP) crisis, trade deficit and indebtedness.

There are a number of factors for the existence of long lasting foreign currency shortage in the country.

The first is export being heavily dominated by few primary agricultural commodities that are pricey and income inelastic. Also, due to the insignificance of the volume of our export relative to that of competitors, the prices for these exports are set for us, sometimes negatively affecting earnings.

Reversely, the heavy dependence of domestic production and consumption on the import of raw materials, capital and consumer goods has exacerbated the foreign currency shortage, as earning from export cannot finance the required foreign currency for imports.

There obviously is a need to diversify exports and specialize in the production and export of commodities that the country has an abundance of to gain a comparative and competitive advantage over competitors. Imports, on the other hand, of unproductive and luxury goods and services should be discouraged and import substitution industrialisation utilised so as to reduce the foreign exchange gap in the country.

Second, the existence of informal and parallel markets within the economy, in which a significant proportion of the country’s income is channelled and circulated within the informal sector, is another factor that exacerbates foreign currency shortage.

The informal sector accounts for a reported half of all foreign currency inflow and outflow. Even though remittance could help in the effort for foreign currency mobilisation, it is severely under exploited due to the fact that a significant amount is channelled through the informal market.

Besides, remittance represents a significant portion of the country’s gross domestic product (GDP) with earnings reaching as high as 4 billion dollars. This amount has created a number of difficulties in measuring the flow of money into the informal sector. The existence of an underdeveloped financial sector, mainly banking, also contributes to a negative destination for the flow of remittance money. This will continue as long as the government continues to fail to develop a legal framework that prohibits and restricts the growth of the informal sector.

The banking industry should set up agents for providing foreign remittance transfer services in the countries that are the largest sources of remittance money. It should also develop a marketing strategy that encourages the channelling of remittance to the formal sector by creating a business partnership with the Ethiopian diaspora by providing banking services that benefit them.

Third, the foreign exchange policy of the government is too tight and restrictive. The government has adopted a devaluation policy as a part of its structural adjustment program (SAP) that is supported by the International Monetary Fund (IMF) and World Bank (WB). Even though the government adopted the policy to improve the competitiveness of exports in particular and the overall economic activity in general, it has failed to bring the targeted results due to the nature and structure of the country’s economy.

Moreover, the foreign currency inflow and outflow, the amount that local and foreign individuals and corporations can carry is limited, minimising borrowing capacity from private banks. This has led to the growth of a parallel, unregulated market that has the potential to divert the flow of foreign currency through the informal channels and increase socioeconomic ills like money laundering and terrorism financing.

Accordingly, the government is expected to review and adjust its foreign exchange rate policy by swiftly liberalizing the foreign exchange regime and making it flexible in such a way that improves the overall economic activity of the country. A range of expert bodies have consistently recommended that the current policy is a deterrent to the economy and is causing unnecessary challenges for the government as it strives to meet its GTP objectives.

The controlled foreign exchange regime is abating the flow of funds through channels outside the periphery of the Ethiopian authority, thus challenging the successful implementation of GTP. More importantly, financial inclusion should be encouraged, by bringing financial service access to the greater portion of the Ethiopian people via an expanding banking network and mobile money.

As the Ethiopian economy grows and its banking industry expands, so does the risk of abuse by illicit financial flows. The government can fix the issue by rapidly liberalising the financial sector and opening up greater access to foreign exchange currency to remove the need for a parallel market and reduce the use of informal value transfer system.

By Kennedy Abebe Kennedy Abebe has a BA degree in economics and is a second year MA in development economics. He currently works as E-banking business development officer at Wegagen bank. He could be reached at tsikal444@gmail.com.